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Exiting a Partnership

Limited partners generally are not responsible for
partnership debts; nonetheless, creditors often demand they guarantee
them. When a limited partner who has guaranteed a debt wants to leave
the partnership, he must satisfy the guarantee or have it cancelled.
How this is accomplished can greatly affect the partnership’s
taxation.

MAS One, a limited partnership, had two equal partners—MAS One
Generals, the sole general partner, and Midland Mutual Life Insurance
Co. (Midland), the sole limited partner. In 1989 MAS One entered into
an agreement to construct an office building using a $14.5 million
loan from Huntington National Bank. The loan required monthly interest
payments, a $2.5 million payment upon completion of construction and
repayment of the balance in 1994. Midland guaranteed the monthly
interest and the $2.5 million payment. When MAS One failed to make the
payments, Midland paid the interest to Huntington and the $2.5 million
in 1991 when it was due. In 1994 Midland decided to abandon its
partnership interest and notified Huntington, agreeing to pay some
money to be released from the mortgage. Also, as a condition of
abandoning its interest, Midland paid MAS One $185,000.

MAS One sold the building the next day for $4.1 million, assigning
the proceeds to Huntington, and Midland paid the bank $8.3 million,
the remaining balance of the loan. On its tax return MAS One treated
the $8.3 million payment as a nontaxable contribution to capital by
Midland. The IRS reclassified the payment as forgiveness-of-debt
income. When the Tax Court ruled for the IRS, MAS One appealed.

Result. For the IRS. When a third party pays
another’s debt, the debtor is considered to have taxable income, so
MAS One would have reported income when Midland repaid the bank. MAS
One argued that this rule applies only when the payor is unrelated to
the debtor. The Sixth Circuit Court of Appeals rejected the argument
because no authority existed for it, but substantial authority existed
for ignoring any relationship when applying the general rule.

MAS One then argued it did not have income because Midland was
obligated to pay the debt. If in fact this had been the case, then MAS
One would have been correct. However, since Midland was obligated to
pay only the interest and the $2.5 million payment, this argument also
failed.

MAS One’s final argument was that IRC section 721 shielded it from
recognizing income. The Sixth Circuit said section 721 did not apply
for two reasons. First, Midland had abandoned its interest before the
debt payment, which, therefore, could not be considered a contribution
by a taxpayer for an interest in a partnership. MAS One’s attempt to
argue substance over form to ignore this fact was rejected. And
second, section 721’s primary requirement is that a contribution to
capital must be in exchange for an interest in the partnership, but in
this case Midland made the payment to sever its relationship with MAS
One. In Twenty Mile Joint Venture, 200 F3d 1268, the Tenth
Circuit Court of Appeals had ruled that payments to sever an interest
were excluded from section 721. The Sixth Circuit concluded that the
precedent set in Twenty Mile was directly applicable to
MAS One and mandated a rejection of the taxpayer’s
arguments.

Taxpayers involved in these transactions will have to consider a
recent code change—the 2004 American Jobs Creation Act amended section
108(e)(8) on cancellation of debt in exchange for a partnership
interest—in addition to the rules established in MAS One. A
partnership now is required to recognize forgiveness-of-debt income to
the extent the amount of debt forgiven exceeds the value of the
interest transferred to the creditor. Therefore, future partnerships
whose debt is cancelled as part of a severance may have to recognize
income even if the transaction meets the requirements of section 721.
However, neither the 2004 act nor MAS One addresses the
possibility the transaction could be a contribution to capital and
treated as tax-free under a general rule similar to section 118, which
applies to corporations.

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